Incorporation of the Royal Ordnance Factories

NATIONAL AUDIT OFFICE

Report by the Comptroller and Auditor General

Ministry of Defence: Incorporation of the Royal Ordnance Factories

Ordered by the House of Commons to beprinted 23 April 1985

LONDON HER MAJESTY’S STATIONERY OFFICE E3.80net

343 This report is presented to the House of Commons in accordance with Section 9 of the National Audit Act, 1983.

Gordon Downey Comptroller and Auditor General National Audit Office 22 April 1985

,., Contents

Ministry of Defence: Incorporation of the Royal Ordnance Factories

Pages Summary and conclusions l-3

Report Part 1: Introduction 4 Part 2: Preparations for incorporation and final Trading Fund account 5-6 Part 3: Arrangementsforincorporation 7-9 Part 4: Postincorporationarrangements 10-11

Glossary of abbreviations 12

Glossary of terms 13

Appendix 14-16 Memorandum of Understanding between the Secretary of State for Defence and the Chairman of Royal Ordnance plc Ministry of Defence: Incorporation of the Royal Ordnance Factories

Summary and conclusions

1. This Report records the results of a National Audit Office (NAO) examination of the arrangements for incorporation of the Royal Ordnance Factories (ROFs) and in particular the financial aspects. The Report deals with the action taken and the costs incurred by ROFs and the Ministry of Defence (MOD) in preparation for incorporation; the proposals for valuation of the opening balance sheet of the new company and the possible effects of this on the proposed later introduction of private capital; and the arrangements for control of the new company by the Secretary of State for Defence (Secretary of State) and accountability to Parliament after incorporation.

2. Specifically, the NAO examination noted that the marketability of the shares of the Company has been enhanced by treating as distributable reserves some El80 million arising from the transfer of net assets from the ROF Trading Fund, in order to meet the special circumstances of the proposed flotation of a previously unincorporated business. The value of the distributable reserves should be reflected in the proceeds on privatisation. These proceeds will not be significantly affected by balance sheet asset values but will depend essentially on actual and prospective profits and dividends. The Report notes that a number of steps have been taken to improve the efficiency of the ROFs and that sponsors of other Government trading services might consider whether there are any lessons to be learned from these. It also notes that although for the time being the Company is expected to comply with Government guidelines for nationalised industries these do not apply in every respect; nor is there provision for the C&AG to have access to the books of account and records of Royal Ordnance plc.

Background 3. In 1974 the ROF organisation became the first service to be financed by means of a trading fund established under the Government Trading Funds (GTF) Act 1973 which was introduced to improve the commercial operation and public accountability of certain Crown services. In May 1982 the Secretary of State announced the Government’s intention to operate the ROFs in a more commercial environment under the Companies Acts with a view to involving private capital in due course. The necessary legislation is contained in the Ordnance Factories and Military Services (OFMS) Act 1984.

4. The assets and liabilities of the ROFs, together with certain other MOD assets and liabilities attributable to ROF operations, were transferred under a Scheme made by the Secretary of State to a new Company, Royal Ordnance plc, on 2 January 1985. Initially the Company is wholly Government owned, and during this period the relationship between the Secretary of State as shareholder and the new Company is set out in a Memorandum of Understanding (MOU) (see

1 Appendix). Detailed plans for the introduction of private capital have yet to be made.

5. Resulting from the NAO’s examination of the arrangements for incorporation, the Report draws attention mainly to the matters summarised in the following paragraphs.

Preparations for incorporation and final Trading Fund accounts 6. The ROF Trading Fund has paid dividends totalling f 116 million to the Con- solid&cd Fund since 1974. The balance of the surpluses on operations, which with MOD and Treasury agreement has been retained as reserves,was expected to exceed f 180 million at 1 January 1985 (paragraphs 2.4,2.5).

7. Costsofmorethanf3.6millionhadbeenincurred byROFsandMODupto 1 January 1985 in preparing the ROFs for incorporation. MOD has also approved the creation of 60 additional posts at an annual cost off 1.5 million to deal with contracts with Royal Ordnance plc which replace the previous simple orders (paragraphs 2.7 to 2.8).

8. After a review of the value of some fixed assetsto the business, a number of assets have been written down or are being considered for write-down by El2 million in total prior to incorporation. These include the TNT plant at ROF Bridgwater, the provision of which MOD justified to the Public Accounts Com- mittee (PAC) of Session 1977-78 (paragraph 2.9).

Arrangements for incorporation 9. The marketability of the shares of Royal Ordnanceplc has been enhanced by providing forthereservesofsomef180millionarisingasaresult ofthetransferof net assets from the Trading Fund to be distributable. Distributable reserves are necessary in the special circumstances of the potential flotation of a previously unincorporated business; they will provide flexibility, for example to meet deficits and maintain dividends irrespective of trading results, and should be reflected in the proceeds on privatisation (paragraphs 3.3 to 3.5).

10. The opening balance sheet of the new Company is expected to be published after I have presented the final Trading Fund accounts to Parliament. Both will be based on the historic cost convention but there will be differences between the two (paragraphs 3.6 to 3.9).

11. A firm of chartered surveyors has assessedthe existing use value of the land and the depreciated replacement value of the buildings transferred from the Trading Fund to Royal Ordnance plc at f 129 million on 3 1 March 1984 compared with the depreciated historic cost in the Trading Fund accounts of f35 million. This depreciated replacement cost valuation is not appropriate for the opening balance sheet of the new company but it will be updated and disclosed in any prospectus issued prior to a share flotation. Further assetsat MOD Research and Development (R&D) Establishments, valued at depreciated replacement cost at f25 million, are also being transferred (paragraph 3.11).

12. The Government has made clear that at privatisation the Company will be valued principally by reference to its earnings capability and prospects but chartered accountants’ advice to the ROFs was that this might not differ materially from the historic cost valuation. The proceeds accruing to the Exchequer on privatisation will depend not so much on balance sheet asset values as on the 2 recent profit record and particularly prospective profits and dividends (para- graphs3.12and3.13).

13. The stimulus of incorporation has led to the introduction of a number of steps to improve the efficiency of the ROF organisation. Sponsor departments of other Government trading services might consider whether there are any lessons to be learned from the ROF experience (paragraphs 3.16 and 3.17).

Post incorporation arrangements 14. Pending privatisation the MOU states that the Company is expected to comply with Government guidelines for nationalised industries, where relevant to its circumstances and not inconsistent with the MOU, but the Secretary of State has no power to direct the Company on specific matters which appear to him to affect the national interest. Nor does the MOU establish arrangements for setting suitable performance aims and, where appropriate, publishing performance indicators to provide information about the control of costs and improvements in efficiency, although MOD have informed me that they are currently developing such arrangements with Royal Ordnance plc (paragraphs 4.1 to 4.5).

15. To secure public accountability sponsoring Ministers of Nationalised In- dustries are required to place the Industries’ annual accounts and reports, including details of performance aims and achievements, before Parliament. There is no requirement for Parliament to be provided with similar information on Royal Ordnance plc (paragraphs 4.6 and 4.7).

16. There is no provision for the C&AG to have accessto the books of account and records of Royal Ordnance plc (paragraphs 4.8 to 4.10).

17. The Secretary of State has expressed his intention that the Company shall pass into the private sector as soon as commercially and financially appropriate, probably by a public offer for sale of the shares, although sales of assets or subsidiaries to third parties are not excluded; but the arrangements for controlling the associated costs and ensuring a fair return to the taxpayer have still to be determined (paragraphs 4.11 and 4.12). Ministry of Defence: Incorporation of the Royal Ordnance Factories

Report Part 1: Introduction

1.1 The ROFs were until 2 January 1985a part of MOD. 1.4 This Act enabled the Secretary of State to make a Traditionally they have satisfied a substantial part of Scheme transferring the assetsand liabilities of the ROFs, MOD’s requirements for ammunition, land weapons and together with certain other MOD assetsand liabilities at- fighting vehicles. In addition they supply goods and services tributable to ROF operations, to a new company incorpo- to other customers both at home and abroad. rated under the Companies Acts in exchange for fully paid up shares.Accordingly a Schemewas made on 20 December 1.2 The Government Trading Funds (GTF) Act 1973was 1984 and laid before Parliament on 9 January 1985. The introduced to improve the commercial operation and public relevant assets and liabilities were transferred to the new accountability of certain Crown services. The ROF Trading holding company, Royal Ordnance plc, on 2 January 1985. Fund Order 1974 (S.I. 1974 No 1106) made under that Act came into operation on 1 July 1974 and the ROF organisation becamethe first service to be financed by means of a 1.5 While the company is wholly Government owned the trading fund rather than by annual votes and appropriations i from Parliament. relationship between Royal Ordnance plc and the Secretary of State in his capacity as proprietor will be governed by the 1.3 In May 1982 the Secretary of State announced the Memorandum of Understanding (MOU) agreed between Government’s intention to operate the ROFs in a more com- him and the Chairman of the Company. Copies of this mercial environment under the Companies Acts with a view memorandum were placed in the Libraries of both Houses to involving private capital in due course. The necessary of Parliament and it is reproduced in the Appendix. This legislation is contained in the Ordnance Factories and Mili- Report summarises the results of a review by the National tary Services (OFMS) Act 1984 which received the Royal Audit Office of the arrangements for incorporation and in Assent on 31 October 1984. particular their financial aspects.

4 Part 2: Preparations for incorporation and final Trading Fund accounts

Ge*erCd meet additional costs arising from incorporation; and to 2.1 Inpreparation forincorporationsevennew companies meet capital expenditure requirements. The accumulated were formed in 1984; the holding company Royal Ordnance surplus retained by the Trading Fund as general reserve was plc; a company for each of the four ROF operating divi- f207millionat 31 March 1984andisexpectedtoexceedfl80 sions, ie Ammunition; Explosives; Small Arms; and million at 1 January 1985(paragraphs 3.3 to 3.5). Weapons and Fighting Vehicles: and two companies to ad- minister the new company pension schemes. In addition, Borrowing and cash balances from 1 April 1983, the Trading Fund assumed from MOD 2.6 The final instalment of ROFs’ debt to the National full responsibility for the management and financing of Loans Fund was repaid in 1984. The cash balance in the salesof its products to overseascustomers thereby making it Trading Fund fell from f87 million at 31 March 1984to f37 autonomous in this area. In the latter half of 1984headquar- million at 1 January 1985and is expected to be extinguished ters staff were moved from accommodation provided by the in the hands of Royal Ordnance plc in 1985. The fall was Property ServicesAgency to commercially leasedaccommo- mainly due to a reduction in advancesby overseascustomers dation in central London. because of completed orders (f22 million): expenditure on the R & D establishments transferred from MOD (f10 mil- Researchand Development Establishments lion); and the settlement of an outstanding claim by MOD 2.2 On 1 April 1984the ROFs took over responsibility for (f12 million). A further reduction of f26 million in the cash running the MOD establishments concerned with the balance was expected to result from the change from a applied research, design and development of certain of their system of bulk progress payments by MOD on ammunition products. These were the Propellants, Explosives and orders to one involving progress payments on individual Rocket Motor Establishments at Westcott and Waltham contracts in accordance with MOD’s normal arrangements Abbey and the factory at Summerfield operated under an with contractors. It is intended that Royal Ordnance plc’s agency agreement with IMI Kynock Ltd. This brought to- borrowing requirements will be met from commercial gether most of the United Kingdom rocket motor capability sources. within the ROF organisation. Costs of incorporation 2.3 The final Trading Fund account for the period to 1 2.7 The 1983-84 Trading Fund accounts identified costs January 1985will reflect this transfer. The associated assets incurred during the year on preparing the ROFs for incor- and liabilities however will not appear in the final Trading poration off 1.O million. Similar costs estimated at f2.5 mil- Fund balance sheet but were transferred directly by the lionwereincurredin 1984-85makingatotaloff3.5 million. Scheme from MOD to Royal Ordnance plc on 2 January ThisincludesROFstaffcosts(f2.0million),accountingcon- 1985. The Treasury Solicitor has confirmed that this treat- sultancyfees(f0.7million), merchant bankingfees(f0.2mil- ment conforms with the provisions of the GTF Act 1973and lion), legal fees (f0.2 million), surveyors fees (fO.1 million), the ROF Trading Fund Order 1974. and promoting the company image (fO.1 million). Trading Fund final dividend and reserves 2.8 MOD have also incurred costs amounting to fO.1 mil- 2.4 TheGTFAct 1973provides foradividend to be paid to lion on merchant banking feesbut could not readily inform the Consolidated Fund in respect of each financial year, re- me of their staff costs on incorporation work. They have presenting a return on public dividend capital and reserves however, approved the creation of 60 additional posts at a invested in the Trading Fund. The Act also provides for the cost of some f 1.5 million per annum to deal with contracts responsible Minister, with Treasury concurrence, to estab- with Royal Ordnance plc which replace the previous simple lish reserves,although the Minister may also direct that any orders. reservessurplus to foreseeablerequirements be paid into the Consolidated Fund. Since the Trading Fund was established Write down of assets in 1974, the ROFs have broadly paid the dividends required in line with the financial objectives set for them during the 2.9 The ROFs initiated an exercise in 1984to identify fixed period, in total f116 million, including 815 million for the assetswhose value to the business was expected to be less final trading period. Since 1979 dividends have been calcu- than the book value. Subsequently they wrote-down plant lated on the basis of a return of five per cent per annum on and buildings by some f2 million in the 1983-84 Accounts. the average net assetsemployed at current values. Further similar writes-down in the 1984-85 Trading Fund accounts amounting to some f 10 million are currently pro- 2.5 The balance of the surpluses on operations, which posed and others may be considered. Four major items have been attributable to both MOD and other sales, has, acquired in recent years account for most of the f 12 million. with Treasury and MOD agreement, been retained as reserves. The ROF organisation considered that a general re- (a) Bridgwater TNT Plant serve was needed to provide a safeguard against the manu- The TNT plant at ROF Bridgwater cost f7 million and was facturing and trading risks implicit in major long term brought into use in 1980. A write-down of f 1.4 million in overseasorders; to support suitable new ventures and devel- 1983-84and aproposed further f2.7millionin 1984-85will opment work; to allow for profit figures derived under the reduce the depreciated book value to a nominal f 1. PAC historic cost convention of accounting during a period of (Third Report 1977-78, paragraphs 50-54) reviewed the high inflation; to permit a measure of price stabilisation and arrangements for the plant’s construction. Although it was increase the ROFs competitiveness in export markets; to likely that adequate supplies of TNT would be available

5 from friendly countries, an indigenous source of supply was @) Bridgwater 420 Gallon Mixer thought desirable, andtheROFs’ calculationsindicatedthat A propellant mixer at Bridgwater is being constructed at a it would be more expensive to rely on imports becauseof the cost of f2.1 million. The new company do not intend to costs of financing and storing the stockpile which would complete the plant becausethe major contracts for which it then be necessary.The ROF organisation assured PAC that was acquired have been sourced elsewhere.The whole of the although the 3,000 short ton plant being installed provided cost is to be written off in the final Trading Fund account. roughly twice the capacity required to meet the anticipated requirements of the British Forces and overseas sales plus limited emergencies,it was only marginally more expensive (c) Bishopton Boilerhouse to buildthanaplant ofhalfthesizeandshouldbecheaperto The boilerhouse at ROF Bishopton is in the course of being operate on a unit cost basis. The ROFs also envisaged large commissioned as a replacement coal-fired plant costing scaleexports of bulk TNT which would make a contribution somef9 million, although theestimated current replacement to fiied overheads. PAC stressed the need for ROFs to cost of an oil-fired installation (which would have been built obtain the best possible export sales and terms to spread but for Government pressure in 1976, when the project was overhead costs as widely as possible. However efforts to sell approved, to continue using coal) is only f5 million. Royal overseas have been unsuccessful becauseTNT has become Ordnance plc have informed me that the value of the new freely available from elsewhere (particularly Iron Curtain plant to the Organisation is being considered in the light of countries), much of it of a different specification and at the fact that it does not work; there is no reliable indication prices at which it would be uneconomic for Bridgwater to of the further costs of making it work and no guarantee that sell. Although the expected life of the plant was of the order this can in fact be done; and the company is investigating of 30years, theROFs havedecided that with thecessation of whether it has any legal redressfor this situation. MOD’s preferred source policy and the introduction of a fully competitive environment, the TNT prices can no longer bear the depreciation charge and remain competitive. (d) Chorley 155mm Plant TheROFsthereforeproposetowriteofftheremainingbook This came into operation in 1976. The remaining f0.6 mil- value of the plant. This will avoid future depreciation lion book value has been written-down because MOD has charges for the plant and enable Royal Ordnance plc to directed its current requirement overseasunder the terms of quote for MOD and other contracts in line with inter- a trilateral worksharing agreement and no further MOD national prices. orders are expected in the immediate future.

6 Part 3: Arrangements for Incorporation

Scheme Valuation of assetsand liabilities (seeGlossary of Terms on 3.1 The Scheme made by the Secretary of State on 20 Page 13). December under the OFMS Act 1984transferred assetsand 3.6 Prior to incorporation, Members of Parliament liabilities to Royal Ordnance plc with effect from 2 January expressedconcern during consideration of the OFMS Bill as 1985and made certain other provisions. It set out the assets to how Parliament could obtain assuranceson the opening and liabilities to be transferred from the Trading Fund, valuation of the new company and the possible effects of although it placed restrictions on the use of specified tools any under valuation should the Secretary of State dispose of for other than MOD work. It also detailed additional assets his shares. In response the Government explained its inten- and liabilities to be transferred, which consist largely of the tion to carry out a rigorous valuation of the assetsto be MOD’s rocket motor research and development establish- transferred and to publish the principles to be applied in the ments and various intellectual property rights. The Secre- Scheme;and to publish as soon as possible after vesting date tary of State however retained the right to use or authorise the opening balance sheetof Royal Ordnance plc, setting out others to use these rights without payment. In exchange for the value of the transferred assets and liabilities, so that the transfer to Royal Ordnance plc the Secretary of State Parliament could question any discrepancies between that was alloted 60 million ordinary shares of fl each in Royal and the closing Trading Fund balance sheet, which would be Ordance plc credited as fully paid. published after I had certified it.

3.2 The Scheme requires Royal Ordnance plc to make an 3.7 I expect to pres’entthe final certified Trading Fund Ac- initial determination of the value of the transferred assets count to Parliament in June 1985. I understand that the and liabilities as soon as practicable after 2 January 1985in opening balance sheet of Royal Ordnance plc will be pu- accordance with principles set out in the Scheme. This value blished after that date. is to be certified by Chartered Accountants appointed by the 3.8 The principles set out in the Scheme provide that the Secretary of State and to be approved by him. The Scheme assets and liabilities transferred to the Company shall be was to be laid before Parliament within one month of valued under the historic cost convention, that their values coming into force. shall be arrived at in accordance with United Kingdom Statements of Standard Accounting Practice and that they Capital structure of Royal Ordnance plc should in aggregatebe consistent with a true and fair view of 3.3 The capital structure of Royal Ordnance plc at vesting the state of affairs of the Company at the transfer date. The day was based on ordinary share capital of f60 million with Balance Sheet of the Trading Fund is being drawn up on the the remainder of the capital employed being represented by same basis. Intangible assets such as intellectual property distributable revenue reserves amounting to some f 180 mil- rights and goodwill are not reflected in the Trading Fund lion, subject to final valuation of the Trading Fund. The and the Schemespecifies they will be transferred at nil value. figure of f60 million corresponds to the closing public di- Despite some initial reservations by both MOD and Trea- vidend capital of the ROF Trading Fund (f35 million) plus sury they finally accepted the advice of the accounting con- the estimated value of the net assetsof the R&D Establish- sultants, merchant bankers and the ROFs that depreciated ments transferred (f25 million). historic cost, which was well understood by the City, was an acceptable basis of valuation. It was broadly realistic and 3.4 Normally, under the Companies Act 1948, any differ- would more favourably reflect the Company’s projected ence between the nominal share capital of a new company earnings than some higher alternative valuation. and the value of its net assetsis treated as a share premium and not available for distribution. Under the authority of 3.9 There will be differences between the closing balance the OFMS Act 1984 however the Secretary of State has sheet of the Trading Fund and the opening balance sheet of specifically provided in the Scheme that reserves derived the Company, in particular for the following reasons. from the Trading Fund shall be distributable. This is to (a) The assetsand liabilities of the R&D Establish- allow flexibility, for example to meet deficits and maintain ments were not a part of the Trading Fund and were dividends irrespective of trading results. Together with the transferred directly from MOD on vesting date (para- absence of any obligation to service loan capital this will graph 2.3 refers); they are therefore subject to a sepa- enhance the marketability of the shares. rate valuation exercise by chartered accountants and surveyors. Since the establishments were previously 3.5 A company’s retained surpluses are available for dis- subject only to the normal MOD vote accounting, the tribution and a Stock Exchange flotation is facilitated where value of the assetsand liabilities being transferred has dividends have been paid in each of the previous five years. not fallen within the scope of my certificate to any In the special circumstances of this proposed flotation of a account. previously unincorporated business, where the objective is (b) The Under Secretary of State for Defence Pro- to maximise the revenue from the sale, I accept that it is curement explained (Hansard 24 October 1984 COI. reasonable that there should be distributable reserves, 740) that where book values of assetswere nil or only a bearing in mind that all payments of dividend prior to the nominal value applied, an economic value might have introduction of private capital will be to the Consolidated to be determined. Fund. However the Government will need to ensure that the value of the retained surpluses is reflected in the price ob- 3.10 It is appropriate, in accordance with normal account- tained on any sale to the private sector. ing practice, for the Trading Fund closing balance sheet to be drawn up on an historic cost basis consistent with pre- prior to transfer, in the casesof British Telecom, Britoil and vious years. As noted in paragraph 3.8, the opening balance Amersham International they were transferred at depre- sheet of Royal Ordnance plc is also to be drawn up on an ciated historic cost. historic cost basis, although generally adopted accounting principles include the concept of attributing “fair values” to 3.13 If the Secretary of State disposesof his interest in the assetsand liabilities at the date of acquisition. Where assets Company by a public offer for sale of its shares, the pro- are transferred from one organisation to another, but not as ceedsto the Consolidated Fund from that sale will depend part of an arms length transaction, an open market not so much on the balance sheet value of the assets but valuation for existing use would be required to determine a essentially on the recent profit record, the assessmentof “fair value”. prospective profits and dividends and the stock market con- ditions at the time private capital is sought. However it is 3.11 The ROFs commissioned such a valuation of their desirable that those concerned with the flotation, including land and buildings from a firm of chartered surveyors in Parliament, should be aware of the “fair vahze” of the 1984. In their report the surveyors noted that the location of assetsat the time of any future sale, whether the latter is by the ROF factory sites and the specialised nature and way of a public offer for sale of sharesor by salesof assetsor arrangements of the buildings were such that they were subsidiaries to third parties (see paragraph 4.11). In the rarely, if ever, sold for existing use, except as a whole busi- meantime, while Royal Ordnance plc is publicly owned, any ness. In these circumstances they were unable to determine under or over valuation of assetsat the date of incorporation the open market value of the assetsbut prepared a valuation would affect depreciation charges shown in the accounts. basedon depreciated replacement cost. This was an estimate of the market value of the land for its existing use, together Pension arrangements with an estimated depreciated current replacement cost of buildings and other site works, making allowance for their 3.14 On 2 January 1985 some 19,000 ROF and MOD age and condition. The valuation assumedadequate poten- employees were transferred to Royal Ordnance plc and tial profitability of the business carried on at each location, ceasedto be members of the Principal Civil Service Pension having regard to the value of total assets employed. The Scheme(PCSPS). They have been given six months in which value of the land and buildings on this basis totalled f 129 to choose between preserving their accrued rights under the million for Trading Fund assetsat 31 March 1984,compared Civil Service schemeor transferring them to a new company with the Trading Fund depreciated historic cost for land and pension schemefor existing employeesonly, providing simi- buildings at the same date of f35 million; in addition the lar benefits to the Civil Service scheme. assets of the R&D Establishments were valued by the surveyors at f25 million. An alternative use valuation at the 3.15 A payment for the value of any rights transferred same time, based on the net realisable amount if the from the Civil Service schemeto a company schemewill be properties were surplus to requirements, gave a total made from the Civil Superannuation Vote (Class XIV, Vote valuation of f20 million but this took no account of the cost 4). The exact amount will be agreed between the Govern- of decontamination of sites, which would be substantial. ment Actuary acting for the Treasury and consulting actua- Although, since an open market valuation was not possible, ries acting for Royal Ordnance plc, after all employeeshave neither valuation is an appropriate measureof “fair value” exercised their options. The Government Actuary’s Depart- for opening balance sheet purposes, Ministers have stated ment have estimated that, if all transferring staff opt to that the higher valuation, which may need to be updated and transfer their PCSPS benefits to the new scheme,a transfer adjusted for changes in circumstances, will be disclosed in value of f230 million will be payable. The bulk of this pay- the prospectus issued prior to any share flotation. This fol- ment is likely to be paid towards the end of 1985 but it has lows the Stock Exchange practice of seeking a valuation for been agreedthat an advance instalment of f5 million should any such prospectus. be paid during 1984-85. This payment will enable the new pension scheme to meet benefit expenditure which arises 3.12 Ministers have made clear that at privatisation the before the bulk settlement is received. A provision of f200 Company will be valued principally by reference to its million is being sought in the 1985-86 Estimate to cover the earnings capability andprospects. Suchan assessmentof the balanceof thepayment to theRoyal Ordnance plc pension economic value of the business could differ from the value scheme. This sum has been provided on the basis that the of the underlying assets (whether measured in historic or majority of officers will opt to transfer their accrued rights. replacement cost terms). Although such a valuation would Should the estimate of the number of optants be wrong, or have been an appropriate method of determining the fair should the economic assumptions underlying the actuarial value for transfer purposes on incorporation, the profes- assessmentchange by the time payment is made, the amount sional advice received by MOD was that it would have been of the payment will be different. The transfer payments are difficult to determine and would have involved a much not additional expenditure. They are sums of money repre- greater degreeof subjective judgement than valuation on the senting the actuarial assessmentof the liabilities being given basis of historic cost, which is well understood and has the up by the PCSPSin respectof staff who opt to transfer their advantage of matching Trading Fund practice. In addition, accrued pension benefits. chartered accountants’ advice to the ROFs was that economic value might not differ materially from the historic cost Measures to improve ROF efficiency value to be determined in accordance with the principles set 3.16 Since the proposals for incorporation were first an- out in the Scheme.Those principles took account of recent nounced in 1982, MOD and ROFs have introduced or pro- precedents for valuation of State owned assetsfor transfer posed a number of measuresdesigned to improve competi- purposes prior to privatisation. Although in the case of tiveness and efficiency. ROFs assumed full responsibility British Aerospace, fixed assetswere to someextent revalued for sales (paragraph 2.1 refers); rocket motor research and 8 development capability was concentrated in ROFs (para- consideration include enhanced pay for certain non- graph 2.2); and MOD’s preferred source policy has been industrial appointments to attract high quality staff in key abolished to expose the new company td competition. areas and a revision of the non-industrial pay system and Within the Royal Ordnance organisation senior manage- bonus schemesto reduce administrative costs. ment personnel with private sector experience have been appointed; major plans are underway and in an advanced stage 3.17 It would have been possible to introduce most of of preparation for relocation of manufacturing facilities these measures while continuing to operate as a trading and introduction of new technology at a total cost of 545 fund, but the impetus for change has derived from the incor- million, in order to improve product design, manufacturing poration proposals. Although some of the changes are methods and management information systemsand permit specific to ROF circumstances, this raises the question more frequent management accounts; and manufacture for whether the sponsor departments of other Government stock, which had only previously been permitted against trading activities might usefully consider whether there are firm MOD orders, is being introduced. Further steps under any lessonsto be learned from the ROF experience.

9 Part 4: Post incorporation arrangements

Memorandum of Understanding (MOU) performance and efficiency cannot be gauged solely 4.1 In his role as procurer of defence equipment the Secre- by successor otherwise in meeting financial targets, tary of State will deal with Royal Ordnance plc on the same which may be achieved by adjusting prices. In the basis as any other defence contractor. There are no detailed competitive environment in which the ROFs are ex- statutory requirements in the OFMS Act 1984governing the pected to operate there may be little scope for increas- relationship between the Company and the Secretary of ing prices in this way but suitable performance indica- State in his capacity as shareholder, but the relationship tors provide information about the control of costs while the Company is wholly Government-owned is set out and improvements in efficiency. in the agreed MOU. Parliamentary control 4.2 The MOU statesthat the Secretary of State expects the 4.6 In order to secure accountability to Parliament the Company to operate as far as possible as an independent nationalised industries are required by their governing company and to act commercially. It provides for the Com- statutes to present annual reports and accounts to Ministers pany to comply with Government guidelines for nation- who in turn must place them before Parliament. Cmnd 7131 alised industries, insofar as they are relevant to its circum- expects these reports to include: the main points in the stancesand are not inconsistent with the specific provisions annual business plans and any Government response to of the MOU. The Chairman and Directors of the Company them; financial targets set by the Government together with are to be appointed by the Secretary of State. the outturn; details of performance indicators and aims including valid international comparisons; and any general or 4.3 The MOU requires the Company to prepare a specific directions given to the industry. medium-term business plan annually, covering a 4 year period, to be agreed by the Secretary of State. The plan will 4.7 There is no requirement in the OFMS Act 1984, or in include a statement of objectives and of expected perform- the MOU which established the monitoring framework to be ance against such objectives and will cover business risks operated by MOD, for Royal Ordance plc to publish similar and opportunities, R&D activity, investment and divest- information on performance and efficiency. Nor is the ment, and financial projections. It will also be used to set the Secretary of State required to place copies of the annual external financing limit for the Company to be agreed as report and accounts of Royal Ordnance plc before part of the annual Public Expenditure Survey. An appropri- Parliament. ate rate of return will be set by the Secretary of State in consultation with the Company after consideration of the plan. C&AG’s lack of accessto Royal Ordnance plc He will agree a ceiling on borrowing and the dividend to be 4.8 I have full accessto the books of account and records paid to the Consolidated Fund. Prior approval of the Secre- of ROFs for the purpose of audit of the accounts of the tary of State is required for new capital expenditure or dis- Trading Fund relating to the period up to 1 January 1985. posals in excessof f7.5 million, and for borrowing in foreign Thereafter the accounts of Royal Ordnance plc will be au- currencies or investment outside the UK. dited by commercial auditors appointed under the Com- panies Acts. Papers submitted by Royal Ordnance plc to 4.4 The Company is required to submit quarterly reports MOD under the MOU will be open to my inspection and I including profit and loss account and cash flow statements shall be able to examine MOD’s contracts with the Company by operating division showing variances from budget; a con- to the same extent that I can examine contracts with other solidated quarterly balance sheet; and updated forecasts of MOD suppliers. However, there is no provision for me to the annual profit and loss and cash flow, and year end bal- have accessto the records of the Company. ance sheet. The Company and the Secretary of State will carry out a stewardship review annually. The quarterly re- 4.9 For the time being Royal Ordnance plc will be wholly ports will be used to monitor performance against the exter- owned by the Secretary of State on behalf of the Crown. The nal financing limit. assets it will employ were either acquired directly from public funds or from Trading Fund resources, which have 4.5 The arrangements set out in the MOU in general follow been enhanced by restricting dividend payments to those re- closely those prescribed in the White Paper “The Nation- quired by the financial objective. For the foreseeable future alised Industries” (Cmnd 7131). There are some variations, the Company will probably be sustained to a large extent by in particular: MOD orders which in 1983-84 amounted to U80 million, (a) Neither the OFMS Act nor the MOU gives the some 58 per cent of turnover. For these reasons in May 1984 Secretary of State power to direct the Company on the Public Accounts Committee expressed concern to the specific matters which appear to him to affect the Secretary of State at the proposed significant reduction in national interest. This could lead to a blurring of ac- the effectiveness of their scrutiny of the ROFs, the oper- countability for decisions if reliance has to be placed ations of which had been a subject of long standing interest to the Committee and to Parliament. on a processof persuasion. @) There is no provision for agreeing performance 4.10 In reply the Secretary of State stated that it was the aimsandsuitableperformanceindicatorsandpublish- intention that the new Company should be a commercial ing them where appropriate, although MOD have in- enterprise independent of Government. To go beyond the formed me that they are currently developing such degree of control to be provided for in the MOU would in- arrangements with Royal Ordnance plc. Industrial terfere unduly with the proper exercise of the Company’s

10 independent operation. The Committee observed that they tion is that it will be by a public offer for sale of the shares, would wish to consider the question of accessand account- although sales of assetsor subsidiaries to third parties are ability further when in due course they examined the not excluded. arrangements for incorporation and their financial conse- quences. 4.12 Although I have commented above on the costs of incorporation and the valuation of assets,until the method Proposals for privatisation and timing of the disposal of the Secretary of State’s interest 4.11 Section 3(6) of the OFMS Act 1984provides that the in the Company have been decided and this has taken place, Secretary of State may not dispose of his shares in Royal I shall be unable to comment on the arrangements adopted Ordnance plc without Treasury consent. In the MOU he has to control the associatedcosts and to ensure a fair return to expressedhis intention that the Company shall passinto the the taxpayer overall. However, significant factors in deter- private sector as soon as commercially and financially ap- mining the successof any method of privatisation will be the propriate, having regard to the business needs of the Com- efficiency with which the Company is managed during the pany. The method by which this is to be achieved is to be period up to privatisation and its commercial prospects at kept under review but the Secretary of State’s present inten- that time.

11 Glossary of Abbreviations

GTF Act Government Trading Funds Act 1973

MOD Ministry of Defence MOU Memorandum of Understanding

NAO National Audit Office

OFMS Act Ordnance Factories and Military ServicesAct 1984 PAC Public Accounts Committee

PCSPS Principal Civil Service Pension Scheme

R&D Researchand Development

ROFs Royal Ordnance Factories Glossary of Terms

Depreciated Historic Cost the cost of an assetincurred at its date of acquisition, reduced by an amount (depreciation allowance) to provide for its wearing out, consumption or other loss of value. Depreciated Replacement Cost the estimated new replacement cost of assets (in the caseof land its estimated open market value in its existing use), reduced by a depreciation allowance for age, condition, obsolescenceand other factors which result in the existing assetsbeing worth less than a new replacement. Fair Value the price at which an assetcould be ex- changed in an arm’s length transaction. Open Market Value the best price at which an assetmight be expected to be sold assuming a willing seller, a reasonable period in which to negotiate the sale, values remain static throughout the period, free exposure to the market, and no bid by a special purchaser. Economic Value the present value of the future profits from the use of assets.

13 Appendix

Memorandum of Understanding between the Secretary of State for Defence and the Chairman of Royal Ordnance plc

Preamble 1. Royal Ordnance plc (the “Company”) is wholly owned by HM Government under the control of the Secretary of State for Defence (“S of s”). This memorandum setsout certain agreedaspects of the relationship betweenthe Company and S of S in his capacity as shareholder in order to allow S of S to discharge his responsibilities to Parliament; it does not govern the relationship between the Company and S of S in his capacity as procurer of defenceequipment, nor does it restrict the rights of the S of S to make requests of the Company for actions or information. 2. In his role as procurer of defence equipment, S of S will deal with the Company on the samebasis as with other defence suppliers.

3. It is the intention and objective of S of S that the Company shall passinto the private sector assoon as commercially and financially appropriate having regard to the business needs of the Company. The method by which this objective is to be achieved will be kept under review by S of S. It is the present intention of S of S that the Company should move into the private sector by way of a public offer for sale of its shares although salesof assetsor subsidiaries to third parties are not excluded.

4. S of S expects the Company (the “Board”) to operate as far as possible as an independent company and to act commercially.

Strategic and Financial Planning 5. The Company will in accordance with normal commercial practice prepare annually a corporate business plan which willcoveroneyearaheadindetailandafurtherthreeyearsinoutline. Theplanwillcoverthebroadcorporateobjectivesand plans for achieving those objectives and will include supporting financial projections for the three years ahead together with a review of the Company’s strategy and planning assumptions for the longer term. It will include the matters listed in the Schedule to this Memorandum (as may be varied by S of S from time to time) and a discussion of those factors which are expected to affect the business of the Company. In drawing up its plan, the Company shall have regard to the objective of S of S that the Company shall passinto the private sector as soon as commercially appropriate and shall endeavour to ensure that the plan is consistent with this objective. The businessplan will be presented to S of S for his agreementone month prior to the commencementof the financial year of the Company. 6. When presenting its business plan, the Company shall identify the major strategic alternatives it has considered and their prospective impact on the matters listed in the Schedule and, in particular, on profit and cash flow. The Company shall, in particular, identify and review the implications of its corporate objectives for the strategy and objectives of S of S as stated in paragraph 2 above.

7. The Board will submit quarterly reports in writing to S of S not later than 45 days after the end of each quarter. Each quarterly report will include(i) a profit and loss account and cash flow statement by operating division for the quarter and cumulatively for the year to date showing variances from budget; (ii) a consolidated balance sheetas at the quarter end; and (iii) updated forecasts of profit and loss cash flow for the year as a whole, as well as a projected year end consolidated balance sheet. S of S may from time to time also require the Company to provide more frequent reports of movements in its flow of funds. On the occasion of the first such quarterly report for each financial year the final results for the previous year shall be considered and the Company shall carry out a stewardship review with the S of S.

8. S of S requires the Company to seekan appropriate rate of return to be set by him in consultation with the Company and after consideration of its businessplan. 9. The annual business plan prepared by the Company will be used for the purposes of setting the external financial limit (EFL) for the Company to be agreed as part of the annual Public Expenditure Survey (PES). The quarterly reports submitted to Sof S will be used for monitoring Company performance against the EFL.

Finance 10. S of S will decide annually, after consultation with the Company, a ceiling on borrowings (which term shall include financial leases)by the Company, within which limits the Company will operate. The Company shall be entitled to seek adjustment to these ceilings.

11. Within the agreed ceiling on borrowings the Company will be free to borrow in sterling from banks or other normal sourcesof credit and shall be responsible to S of S for ensuringthat theterms of any borrowing are the best available in all the circumstances. Borrowing in foreign currencies will not be undertaken save with the approval of S of S. The Company will

14 be able to enter into UK financial leaseswithin the guidelines laid down from time to time by S of S. Leasesoutside the UK will require S of S’s prior approval.

12. The Company will be expected to comply in so far asthey are relevant to its circumstances and are not inconsistent with the specific provisions of this Memorandum with any HM Treasury financial guidelines for nationalised industries as may be issued from time to time and which will be notified to it by S of S.

13. The Board will consider and settle with S of S an appropriate level of dividends to be paid on the shares of the Company.

Government controls 14. Saveas may be expressly agreed by S of S or approved by him as part of the business plan, the Company will not: (i) significantly diversify its business away from defence products; (ii) enter into any new investment involving capital expenditures of more than f7.5M (or such other figure as S of S may stipulate; (iii) dispose of assetsor businesseshaving a net tangible worth of more than f7.5M (or such other figure as S of S may stipulate); (iv) issue any shares or grant rights over shares; (v) enter into any exclusive trading agreements (including joint ventures) with any other Company, person or firm, other than in relation to a specific project or the design, development, manufacture or sale of specific products; (vi) give guarantee or other off balance sheet financial commitments other than in the ordinary course of business in excessof f7.5M. For this purpose normal bid, advance payment and performance bonds given in relation to sales contracts shall be considered to be in the normal course of business; (viii) invest outside the UK. The Board 15. The Chairman shall be appointed by S of S. The terms of employment, including remuneration, of the Chairman shall be determined by S of S after consultation with non-executive Directors of the Company. 16. Executive Directors of the Company shall be appointed by S of S after consultation with the Chairman. The terms of employment, including remuneration, of Executive Directors shall be determined by the S of S. The Company may submit recommendations from a Remuneration Committee of the Board. The Remuneration Committee shall comprise the Chair- man (as chairman) and two or more non-executive Directors as agreed with S of S. 17. Non-Executive Directors of the Company shall be appointed by S of S, and their remuneration fixed by S of S, in each caseafter consultation with the Chairman. Audit 18. The Auditors of the Company shall be instructed by the Board to draw to the attention of S of S matters of which, in their opinion, a prudent controlling shareholder would reasonably wish to be made aware. 19. S of S shall be entitled to meet privately with the Auditors to discuss the affairs of the Company. Duration of this Memorandum of Understanding 20. This Memorandum has effect for as long as the Company is wholly owned by HM Government; should the Govern- ment reduce its 100% shareholding the Government will consider if any changesin the MOU are appropriate.

M. R. D. Heseltine F. Clarke Secretary of State for Defence Chairman Royal Ordnance plc Ministry of Defence 20th December 1984

15 Schedule to Appendix

Matters to be treated in the Annual Plan

1. Business 1.1 A statement of the objectives of the Group, of any proposals for change and of anticipated performance against such objectives. 1.2 Description of principal businessesin which the Company and its subsidiaries (the “Group”) are engaged, and the principal plans for amendment thereto or development thereof. 1.3 Discussion of the major business risks and opportunities foreseen by the Group. 1.4 Review of the competitive position of the Group in its various markets. 1.5 A description of all existing and proposed material joint ventures and overseasinvestments of the Group, with an indication of the scale of investment and risk involved. 1.6 Review of, including future plans for, research, design and development activity, identifying projects and distinguishing funded work from being conducted at the risk of the Group. 2. Investment and Divestment Plans for capital investment and divestment by the Group, outlining their financial implications. 3. Finance 3.1 A statement of the major assumptions used in preparing the projections and of the material sensitivities. 3.2 Projected turnover and profit and loss account for the year, analysed by division and by major product group within division, and compared with the previous year. 3.3 Projected sources and application of funds, analysed by division and compared with the previous year. 3.4 Projected opening and year end balance sheetsand an analysis of capital employed by division. 3.5 Projected quarterly levels of borrowing. 3.6 Projected off balance sheet commitments, distinguishing, in outline for the first year of the plan between bid, advance payment and performance bonds and other obligations given in the ordinary course of business, and other commitments. 3.7 Proposed levels of dividend. 4. Organisation 4.1 An outline of the main organisation of the Group and of any proposals for change. 4.2 A statement of the number of employees of the Group, and where they are located, and an indication of likely changes.